Given the seemingly counterintuitive nature of the dollar’s recent depreciation, it is hard to know whether we should welcome the decline or be alarmed. As is often the case, the response differs depending on whether we take a short or medium-term perspective.

An apparent anomaly

Between January and early September 2017, the dollar’s decline can be explained by the change in the 10-year yield spread in the eurozone’s favour, although the yield on US treasuries remained far higher than for the Bund. It is the movement since September that has caught our attention: wider yield spreads in favour of the US for both 10-year and 2-year paper were accompanied by a decline in the dollar. We see several possible explanations for this apparent anomaly:
1) The market is of the view that the monetary tightening cycle in the US is already well advanced, whereas it has not begun yet in the eurozone, feeding expectations of tighter yield differentials.
2) The ECB’s quantitative easing programme triggered capital outflows (selling of bonds in euros), but robust growth is now more likely to attract foreign capital, notably in the equity markets.
3) The combination of a current account surplus in the eurozone and a US current account deficit is creating a “natural” disequilibrium in demand for the euro, which must be neutralised by capital flows. However, the latter tend to follow a logic of their own. The prospect that US fiscal policy could trigger a deterioration in the current account balance risks creating a twin deficit problem which could weigh on the currency unless yields rise sufficiently (see also below: point 11).
4) Based on purchasing price parity (+/-1.28 USD or even slightly higher, depending on the source), the euro is still undervalued versus the dollar
5) It is even more undervalued based on its long-term equilibrium rate, which takes into account factors like inflation, productivity and net assets abroad.
6) The risk of surprise is biased in favour of the euro: in Davos, US Treasury Secretary Mnuchin created a big surprise when he came out in favour of a weak dollar. Although President Trump later corrected the message, it may have nourished some fear among market operators. In the eurozone, in contrast, there is speculation that the ECB could adopt a (slightly) more aggressive tone concerning the winding down of QE.
7) The Chinese authorities have allowed the renminbi to appreciate against the dollar by about 10%, which might influence the euro’s strength against the dollar.
8) The favourable cyclical environment in emerging markets supports investor interest and boosts local currencies to such an extent that the dollar is increasingly being used as the currency to finance carry trade strategies.
9) Japanese investors apparently consider positions in their own currency as a good way to diversify against the risks arising from their investments in risky instruments (global equities, etc.), based on the view that in a ‘risk-off’ environment the yen would act as a safe haven and strengthen versus the dollar. European investors might be applying the same reasoning. This would undermine demand for the dollar.
10) In a recent speech in Dublin, Benoît Cœuré of the ECB explained that it was more attractive for a Japanese investor to invest in German bonds on an currency-hedged basis than to make a similar investment in US bonds, and this spread has been growing ceaselessly since July 2017.
11) Investors might be concerned about the significant increase in the US Federal deficit following recent tax cuts and other measures. This, combined with the reduction in the size of the Fed’s balance sheet, means a big increase in the gross borrowing requirement. This reaches a level which is abnormally high for this phase in the cycle. Seen in this light, the upturn in long-term rates and the dollar’s decline are serving as adjustment variables to attract non-resident capital: the more limited the increase in US yields, the bigger the required depreciation of the dollar to attract foreign investors based on the view that eventually the dollar will strengthen again. However, we have to keep in mind that at current levels the dollar is still trading above its fair value versus the euro.

EURUSD: The same tendency should continue in the coming months

This list of potential explanations is long and probably not exhaustive. It is also worth keeping in mind that at any given moment, exchange rates are typically determined by a limited number of factors that may quickly replace each other over time, which explains the volatility of exchange rates: to state the obvious, they don’t move in a straight line. Our forecasts call for a continuation of the tendency observed in recent months: after a small correction in the second quarter, the euro should resume its upward move and rise to USD 1.30 towards the end of 2019. Robust eurozone growth should make it all the more resilient in the face of such prospects, especially since the dynamics should be very gradual. As to the impact on inflation, much will depend on the effective exchange rate of the euro and domestic sources of inflation (especially wages).

Spillovers depend on the short or medium-term perspective

For emerging markets, the absence of a (significant) appreciation of the dollar is good news, given their dollar-denominated debt and the negative relationship between commodity prices and the dollar, a point which is particularly relevant for commodity exporters. For the United States, in contrast, the dollar’s slide is equivalent to monetary easing. Whether directly (through import prices) or indirectly, this could drive up inflation and force the Federal Reserve to tighten policy more. This in turn may end up weighing on market sentiment and on the economic outlook. Clearly, the analysis and its conclusions can be very different depending on whether we take a short or medium-term perspective.

The French version of this text was published in L’AGEFI Hebdo on 1 March 2018